 Inflation is still higher than we want it to be and it continues to affect us all. Companies have put up prices as their expenses have risen and workers are pushing for higher wages to cope with the cost of living. For the next three episodes we've got something special for you on offer. The ECB podcast summer school. In this mini-series we'll take a deep dive into the nature of the inflation that we're currently seeing. We'll take a closer look at the main way of fighting it, our key interest rates, and we'll unpack the role of banks in passing on the impact of our monetary policy to companies, to you and to me. So welcome to the ECB podcast summer school, helping you understand what's going on in the economy and central banking. My name is Katie Ranger. I'm very happy to have ECB chief economist and professor Philip Arlene here in the studio to break this all down for us. Philip welcome back to the podcast. It's a pleasure to be here. Now inflation has been above our target for almost two years. We know what's caused this, a complex combination of factors that include pandemic related supply chain bottlenecks, Russia's war in Ukraine and the related energy crisis, and a post-pandemic rebound in demand. We've spoken about this several times on this podcast. Now we get data on inflation every month. The latest set of figures showed the inflation rate falling to the lowest figure since the beginning of 2022, which is certainly good news. But all in all, it still seems uncertain to many people where prices are going to go. Philip what is making it trickier to understand how inflation will develop? Well I think you've answered your own question in your introduction. Just look back at these years. I joined the European Central Bank in summer 2019 and early 2020 we had to start the pandemic. And the pandemic I should emphasize really can be thought of as having two phases. One we all remember those horrible months of lockdown. So in those in that period if you like people were at home there was very little economic activity and in the initial months of the pandemic in fact there was downward pressure on inflation because the economy was so inactive. Then fantastically the vaccines were invented and really from 2021 onwards there was a big resurgence in the world economy. And that's a lot of dislocation. Put the world economy into sleep. Then reactivators. There's a lot of dislocation. A bit like what happened previously with World War One and World War Two. The dislocation of that did lead at the end of those episodes to an inflation research. You can't just flip the switch basically. Right. So that if you like is ongoing. Although the pandemic is behind us from a public health point of view. Realistically it does take time to settle down. And then as you mentioned especially here in Europe from February 2022 onwards after Russia's unjustified invasion of Ukraine that added a spectacular surge in energy prices. Now that has reversed the amazing efforts of everyone in Europe to cut down on use of gas, cut back on energy, led to a spectacular reversion in energy prices in recent months. But even that still takes time to work through the economy. So these are unusual episodes. Economics works by looking at the past and saying okay based on past patterns how quickly would inflation come back to 2%. And essentially the work of the ECB staff is to work out given these very unusual factors what is a reasonable timeline. And what we have in our projections is inflation to come down quite a lot later this year. But getting all the way back to our 2% targets it's essentially scheduled more or less for 2025. But again that assumes also that we deliver on our commitment. We deliver on our commitment in terms of making sure that interest rates will help that process. Okay so we're dealing with a very unusual situation here basically. Now usually policymakers look at what we call underlying inflation to understand how inflation will progress in the future and indeed fill it back on our last podcast together in June. We talked about how underlying inflation is all about trying to assess what will have a lasting impact on prices once the dust of any shocks like the ones we've been seeing settles. You essentially remove the volatile prices of things like energy and food to get a better idea of price developments. Now the ECB has just published a box as part of its economic bulletin that looks at how useful a measure underlying inflation is these days and listeners as always you'll be able to find the link in the show notes. What's your view on this? Is underlying inflation still a useful measurement in today's rather atypical environment? So I think the way you phrase it at the end is the critical issue. The concept of underlying inflation is permanently useful. We are always searching for as you say when the dust settles. When the dust settles what is the underlying pattern of inflation because that is really from a monetary policy point of view what we need to bring back to 2%. Because of the pandemic, because of bottlenecks, the unusual surge in demand in the last year for say for example for tourism, working out these measures is more difficult than normal. But again that's where the work is. The measures do have to be modified. That's for sure. To take account of this the very large change in energy prices and if you like the rotation in the pandemic where initially people could not go out but they could still order online goods to their home. So home gym if you're working from home office, new business equipment whereas more recently people are definitely have returned to tourism, entertainment and so on. So what I would say is conceptually we're very focused on underlying inflation but it's more work than normal to work out where that is. So what I would say is we have mixed messages and this is fundamentally why monetary policy at the moment is tricky. In one direction as we already talked about they're very rapid for the energy prices. We are confident we'll bring down costs across the economy. Every sector uses energy, lower energy prices and the easier supply chains now with the bottlenecks over will push down inflation over time. On the other hand what's happening this year is the high inflation we saw last year. I remember inflation was a 10% in the area last autumn. It's basically pushing up wages this year. And so what we say is that the domestic component of inflation coming from rising wages and also firms looking to rebuild profits is pushing up underlying inflation. So this force is working in opposite directions and this is why we're very data dependent. You know as we go into the autumn we're going to be hunting for clues looking at the incoming data essentially to see which of these forces is getting stronger which of these forces is getting weaker. Now you mentioned wages and profits there are two things that are affecting underlying inflation. I want to zoom in a little bit on those. What kind of things are pushing firms to put up their profits and what effect will that have on wages as well and perhaps also what how do people perceive these prices? At what point do they become unwilling to accept higher prices as well? What kind of considerations going to all that? So I think it's very interesting and the ECB in the last few years has developed if you like what's called a consumer expectation survey. So now we have a multi-country survey every month and it's super interesting because I think maybe a dimension of inflation that we all need to think about is when do people just accept it? Well prices are going up because there's inflation in general versus prices are going up because this firm is trying to exploit me. And in our recent survey we exactly asked this question and essentially so far people understand that the dominant reason inflation went up so quickly was rising costs especially energy costs. Next on their list was indeed profits and bottom of their list was indeed wages. And I think that was a kind of a good description of what happened last year. But that is changing over time. So now from that kind of cost structure point of view firms can no longer claim that energy prices are going up but they can now say well that's easing under the hand my pay bill is going up. Because people are asking for higher wages to recoup the cost. And that is true to some extent. But the other leg of profitability has basically been the level of demand. Now Europe has not had a general booming economy but what is true is at the level of a sector for example tourism. Last year after the pandemic there's a surge to book holidays. There's a surge to go out to restaurants. And at that point there was still supply was limited. Many hotels closed down. Many airlines reduced the number of planes that they flew. And so in that circumstance with a big increase in demand limited supply firms were definitely tempted to raise prices quite a bit. And we saw that in rising profits. So this year we do think that demand is normalizing. It's not back to normal. People this summer as we speak it's still a pretty strong tourism summer in Europe. By the way not just Europeans but clearly a lot of people from America especially interested in taking a holiday in Europe. So we don't think that the profit dynamic is over. But we are emphasizing this is something we need to see. Not all of the wage increases can be passed on to consumers. And so our assessment that inflation will come down does rely on a calculation that having had quite a lot of profitability last year that this year and especially going into next year firms will just have to live with lower profits. And listeners will be sure to put a link to that very interesting consumer expectations survey that Philip mentioned in the show notes. Now a lot of the factors that we've talked about that are affecting inflation at the moment actually lie beyond the control of a central bank. Things like energy prices and Russia's war in Ukraine. So my question is what can monetary policy do in this environment Philip. So the ECB has always been crystal clear that basically our promise to Europe is that we will make sure inflation comes back to our two percent target in the medium term. So we don't promise that every month inflation will be a two percent because as you say major shocks can happen. The net effect of the pandemic with the reopening phase was the drive up inflation. The net effect of the Russia's invasion of Ukraine was the drive up inflation. And there's been other global factors. And let me mention something that's quite topical now is also with the very hot summer in Europe. And all the talk about El Nino this autumn food prices are also being pushed up by by by weather. So inflation can go up and it can go down for global factors. However what we cannot tolerate and this is where the ECB comes into play is we cannot sit passively and accept that inflation will remain too high or too low. We have to act. And so it's not about where the inflation came from. So in my assessment the inflation mostly came from the factors you listed. But it's a job of the European Central Bank to make sure inflation doesn't stay high that it's guided back towards our two percent target in a timely manner. Well before we wrap this topic up we always ask our guests for a hot tip linked to what we've been discussing today so that our listeners can learn even more about it. Philip do you have something to share. So the phrase hot tip on such a somber topic such as inflation. Let me say that I do have a suggestion. So here in Frankfurt in the Historical Museum there's an exhibition about it. It's called an exhibition about hyperinflation. But in fact more generally it's a very interesting and very visually persuasive history of inflation going back many centuries and all the way to the present day. So for people here in Frankfurt or if you're planning a visit this exhibition runs until the 10th of September. But maybe online you can also find some resources at the Frankfurt Historical Museum. That's a great hot tip. I've been meaning to go and it's on my list of things to do over the summer. So thank you for that Philip. Well that brings us to the end of this episode. I want to thank ECB Chief Economist Philip Arlayne for digging deeper into this really important subject for us. Listeners be sure to check out the show notes for more on this topic. You've been listening to the ECB podcast Summer School with Katie Ranger. If you like what you've heard please subscribe and leave us a review. Until next time. Thanks for listening.